The myriad of problems facing the multi-family industry are rampant right now in the news.
Indeed, the prevailing thought is that there is substantial blood in the proverbial water. Of course there is truth to some of these articles. This is not a particularly easy time to own and operate multi-family property.
It often seems like once one issue subsides another one rises almost immediately. So, that begs the question how do you push forward?
Or to better ask the question Steve Carrell as Michael Scott said on the Office, “You know what else is facing 5 Goliaths? America.” Michael ends his line of thought with the timeless question, “So do we just give up?”
The answer of course is no or, as Michael said in the same episode “David will always beat Goliath”.
So, let’s evaluate the three Goliaths facing the multi-family investment world: interest rates, non-controllable expense increases, and inflation.
Goliath #1: Interest Rates
Problems caused by higher interest rates are well documented in our industry. All the short-term floating rate debt taken between 2021 and 2022 matures between 2024 and 2025.
Many of these are “underwater” as the values in today’s world (which are partially derived from interest rates) aren’t high enough to support the current debt (from ’21 and ’22), which means that investor equity is wiped out – at least on paper.
Indeed, over the last 12+ months some investment firms have been waiting for values to crash for a repeat of the buying opportunities that existed post 2008. While there is pain in some individual deals, overall, throughout the industry David will always beat Goliath.
Occupancy and rent growth continue to remain strong. Which means that the most basic fundamentals of multi-family ownership continue to remain strong. With the fundamentals in tow, a sponsor just needs to focus on fighting through the hard times caused by interest rates.
First and foremost, never miss a mortgage payment. As long as you keep paying your mortgage, banks are going to want to work with you. Remember, most banks don’t want to foreclose on a deal and then have to manage it and sell it themselves.
With current debt serviced, sponsors can then wait for stability to hit our industry. While interest rate reductions would create a huge spike in valuations, stability is its own win for sponsors. If rates do stay higher for longer, then long-term lenders will adjust accordingly.
To that point, earlier this week HUD announced that they are potentially going to start increasing leverage and decreasing minimum debt service coverage requirements. What that means for sponsors/owners is even if rates don’t fall, we can still defeat the interest rate Goliath as the market establishes a new normal.
Goliath #2: Non-controllable Operating Expenses
A new normal is also a great way to describe the next goliath: non-controllable operating expenses.
For those unfamiliar with the term, non-controllable operating expenses typically refers to property insurance premiums and real estate taxes. We refer to them as non-controllable because as you might expect sponsors/owners have no control over these expenses.
Taxes have always been an issue to deal with. That is nothing new, however, insurance is another story.
When we purchased our first deal in June 2017, insurance costs were amongst the lower cost expenses of operating an apartment complex. Now, insurance costs are often as high if not higher than real estate taxes.
What’s worse is that insurance policies are written on a year-by-year basis, so expenses can continue to increase unchecked.
Different sponsors/owners have different methods for dealing with this. Some people have started to “self-insure” which basically means paying an insurance company an annual premium but in the event of a loss you are responsible for paying for all damage. This option is less attractive given the frequency of severe weather damaging buildings.
Others, like us, opt for creating a master insurance policy. This works if you have a larger portfolio, but even this is ineffective in today’s world. In February 2024, our master policy increased by 30+ percent.
While we may not be able to “defeat” property insurance, we can offset it. If insurance expenses increase then you could decrease other expenses and achieve the same bottom line. That is how Vesta has handled insurance.
However, there is another method which is increasing rents on tenants. Of course, for non-investors reading this, that sentence alone is enough to make you cringe.
Goliath #3: Inflation
The never-ending cycle of general living expenses increasing is the final goliath – inflation. Inflation has hurt all of us. Whether you are feeling it at the supermarket or in the commercial real estate world, the pain is omnipresent. It is also interconnected.
Residents who are seeing higher prices in every facet of their lives can ill afford another round of rent increases.
In property management, we used to say that if a prospective resident makes 3x monthly rent then they can sustainably afford rent. In today’s, world 3x is dangerously close to unsustainable if not already there.
But this issue is further compounded by the lack of general wage growth. If wages grew at the same pace as expenses, then multi-family operators could increase the ration to 4x and create the same sort of safety net. However, as many property managers know, outside of the luxury space not many people cover at 4x rent in today’s world.
So, what can we do? How can operators adapt? First and foremost, we must accept that which we can’t change.
When I started Vesta, we used to target 10% cash on cash returns to investors with reasonably conservative underwriting. In today’s world, we are targeting 6% -7% year one returns partially because we are uncomfortable raising rents more than a few % in the first few years.
Beyond that we are focused on creating environments that provide our residents with the security they need to continue to be successful in their own lives.
Finally, we can focus on controlling what we are putting out. If we limit our own expenses as best we can, then we can be less dependent on rental increases and thus help our residents get out of the vicious inflation cycle.
For as many problems are facing the multi-family space in the moment, I for one continue to feel blessed to be in it.
Despite all these crazy economic headwinds, we have purchased new deals, sold existing deals, and refinanced out of floating rate debt all within the first 4.5 months of 2024. We have also increased wages for our employees, focused on our internal property management, and sincerely tried to make life better for our residents.
I guess in the end I can’t say it any better than Michael Scott, “David will always beat Goliath.”
